Jan 312011

The Performance-Based Pricing Fallacy: Part 2

In Part 1 we demonstrated that the Law of Diminishing Marginal Returns dictates that revenue sharing/commission and CPA models do not create the positive incentives they are widely thought to create. In fact, they create disincentives to push the limits.

However, even if the math suggested otherwise, there are at least 3 other grievous problems with "performance-based" pricing models.

  1. Performance Metrics Aren't Simple. In eCommerce, CPA rewards a $10 order the same as a $500 order, which doesn't make sense. Revenue sharing rewards a $100 dollar sale -- with only $10 in margin -- more than a $50 sales with $25 in margin, which doesn't make sense. Even a margin sharing arrangement has it's problems in that: they track 'demand' orders, some of which will cancel; and more pressingly there are often other performance factors that should be included that typically aren't. You might be more willing to pay for new customers than existing customers, or business customers rather than consumers, and lifetime value considerations are completely ignored by these incentive structures. This doesn't just mean the vendor doesn't have an incentive to do the right thing, it can mean they absolutely have an incentive to do the wrong thing.
  2. The Metrics Commonly Used Can Be Artificially Inflated. Even retailers with real time credit card authentication have seen instances of fraud, with commissioned affiliates placing orders on line then canceling later. It's not hard to set up a network of folks to share in that profit. For lead generation, and other soft performance metrics, fraud is much simpler to perpetrate. Page views? Time on site? Downloads? Videos watched? Networks of 'bots can fool any fraud detection effort. But even if we ignore the possibility of fraud, it's easy to cook the books."Fill out this free application and you'll get..."; whether it's promotional language, or placement and prominence on the site, it can be trivially easy to increase the number of leads generated without increasing the number of quality leads. This is the point, all leads are not created equal. A mortgage loan application from someone in Beverly Hills is likely more valuable that a similar application from someone in a less swanky neighborhood.
  3. Commissions Are Paid For The Wrong Performance. In paid search, paying commission to a vendor for someone searching for your company by name is the definition of insanity. Someone searching for you by name (or by your name + coupon) was not compelled to do so by the ad that showed up after they searched! Similarly, crediting re-targeting or display with every order placed following an impression gives commission to far more non-incremental orders than incremental ones. Imagine the "uber ad" that is shown to anyone who boots up a computer or phone one day: did that ad drive all your web business that day? Of course not.Finally and obviously, attribution is a big deal here. Comparison Shopping, Affiliates, and Display Re-Targeting are often priced as revenue sharing agreements, and our attribution modeling system consistently shows that 50% - 80% of the credit for these last touch attribution channels should go to other programs that are really driving the business.

To reiterate a comment I made on the Part 1 post: there are certainly fine management firms that work hard and do what is in their clients' best interest under some sort of performance-based pricing model. My point is simply that they are not doing good work because of the incentive structures created but rather in spite of those negative incentives.

Agencies perform well or badly because of the quality of their staff, the quality of their tools, their experience, and their long-term vision for profitable growth. Their reputation, and the quality of their client references will tell you more about their work ethic than any pricing model.


11 Responses to "The Performance-Based Pricing Fallacy: Part 2"
billy wolt says:
Great posts George. I'm have never been a fan of the PFP model or % of adspend model. PFP leads to what you described in part 1, the marketer going after the cheap traffic and nothing more, and the % model leads the marketer to spend more while disregarding performance. I've always charged my clients a flat fee. The fee is based on the following: Potential and Time. Time: how much time do I expect to be putting in each month (based on size of account, or how big I plan on making it) Potential: how much revenue do I think i can generate. 2 clients might take me the same amount of time each month, but I would be stupid to charge both the same amount if one generates $10k in revenue and the other generates $100k. Sometimes the client makes out like a bandit because their campaigns blow up and my figure seems low.
Thanks Billy, yeah, we're crazy enough to think that the fees should have something to do with how much work you do, the value of that work to the client, the quality of the work, etc...none of which are particularly easy to predict. Bottom line, vendors need to be paid fairly and they need to provide valuable service commensurate with those fees. Any type of incentive structure can be "gamed"; we think advertisers should focus less on the pricing models and more on the vendor's track record for providing valuable service.
Great follow up post George. Like Billy I also use flat fee, then just gets incentives based on performance, which is of course the client's prerogative. I'm currently working on a combination of PFP and % spend with a client, of which I'm not sure would work as it's just complicating matters as far as I can see.
Excellent post as usual! However I disagree with your point on not paying commission on brand bidding - Sure that customer already has huge intent, but if they search your brand name and find a competitor (or a cheeky affiliate) Ad more compelling, you can quickly lose a large volume of sales. I also think Brand PPC is important from a branding perspective and if you don't pay your PPC agency to manage this professionally, you could be losing out. In terms of pay structure I am a big fan of the % of spend model with a clear ROI target - i.e. spend as much as you want as long as you keep the ROI above X%. This gives the agency an added incentive to 'squeeze more blood out of the stone' so to speak; growing the business by improving efficiency.
Thanks Michael. I totally agree that it makes sense to bid on your brand name, and agree with Sid Shah that that must be done with some thought. For firms that do a great deal of offline marketing 70 - 90% of their paid search sales/leads/etc may come on their brand name. Paying a vendor 70 - 90% of their fee based on 'managing' brand ads is crazy. As a percentage of spend, brand ads constitute a much much smaller fraction of the media buy, so the fees are more in line with the work you want to encourage: the competitive non-brand piece. We too are fans of the % of spend model with ROI targets.
Thanks Jun, yes the complexity of PFP models just makes them awkward. Getting into a debate each month about who drove which orders/leads seems like time poorly spent. % of spend also allows advertisers to task their agency with all kinds of metrics beyond leads or sales (eg attracting more of one customer type and less of another) which may cost the agency commission in a PFP model but doesn't in a % of spend system.
Dave Shapiro says:
What are your thoughts on a rolling CPA model in which the vendor gets paid more for each lead they bring? For example, the first 50 sales the vendor gets 25%, the next 50 sales they get 30%, etc., up to a certain cap agreed upon by both parties.
Interesting idea, Dave. It certainly addresses the diminishing marginal returns problem in part one, but it seems like it still suffers from these other issues mentioned in part 2 above.


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